Unit 20 Answers To Exercises PDF

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UNIT 20EXERCISE 20 ASSESSING THE ECONOMIC IMPACTS OF GLOBALWARMINGIn 1896, Swedish scientist Svante Arrhenius estimated the impact ofdoubling CO 2 concentrations in the atmosphere, and later suggestedthat ‘the colder regions of the earth’ might want to burn more coal so asto enjoy a ‘better climate’...

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EXERCISE ANSWERS UNIT 20

UNIT 20 EXERCISE 20.1 ASSESSING THE ECONOMIC IMPACTS OF GLOBAL WARMING In 1896, Swedish scientist Svante Arrhenius estimated the impact of doubling CO2 concentrations in the atmosphere, and later suggested that ‘the colder regions of the earth’ might want to burn more coal so as to enjoy a ‘better climate’. In the next century, entire countries may disappear as the level of the oceans rise in response to the melting of the West Antarctic and Greenland ice sheets.

Eileen Tipoe UNIVERSITY OF OXFORD AND UNIVERSITY COLLEGE LONDON

1. Find out what you can about which regions, industries, occupations, firms, or cities are likely to be: a. most positively affected by climate change b. most negatively affected by climate change 2. What are the main reasons why the effects of climate change differ across these groups?

Answer 1. An Investopedia article (https://tinyco.re/9779613) discusses some industries and occupations that will benefit from climate change, which include: • Insurance companies, who will be able to raise rates as the incidence of natural disasters increases. The prevalence of natural disasters may also encourage more people to purchase insurance. • Arctic shipping companies, whose costs have reportedly decreased by $500,000 per trip due to melting ice, which allows them to travel along the Arctic Circle instead of across the Indian Ocean. • Industries generating solutions to climate change, including construction companies that devise ways to prevent coastal flooding, the renewable energy industry, hybrid car producers, and manufacturers of basic products that deal with sun exposure e.g. umbrella, eyewear, and sunscreen companies. In terms of regions, a journal article (tinyco.re/6585394) from Nature estimates that economies are most efficient in production at around 13 degrees Celsius, so countries colder than this (such as Russia, Mongolia, and Canada) will benefit from global warming. On the other hand, countries above that temperature will experience a slowdown in productivity. 2. The map below shows the locations most negatively affected by climate change, according to the type of issue faced. Source: Union of Concerned Scientists. 2017. Climate hot map. (http://tinyco.re/0873434)

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According to this report (tinyco.re/7310429) by German Watch and this report (tinyco.re/9558725) by the UN, Africa, Southeast Asia, Latin American countries that depend on water from glaciers (e.g. Bolivia, Chile, Ecuador, and Peru), and small island developing nations (e.g. Bahamas, Jamaica) will be most negatively affected by climate change. 3. Students should provide a concise summary of their findings.

EXERCISE 20.2 CLIMATE CHANGE CAUSES AND EVIDENCE Use information from the National Aeronautics and Space Administration web page on climate change (http://tinyco.re/5897476), and the latest report of the Intergovernmental Panel on Climate Change (http://tinyco.re/9013146) to answer the following questions: 1. Explain what climate scientists believe to be the main causes of climate change. 2. What evidence is there to indicate that climate change is already occurring? 3. Name and explain three potential consequences of climate change in the future. 4. Discuss why the three consequences you have listed may lead to disagreements and conflicts of interest about climate policy. (Hint: You may find it useful to draw on your answers to Exercise 20.1 about the winners and losers from climate change.)

Answer 1. The main cause of climate change is believed to be human activity that exacerbates the greenhouse effect (warming due to the atmosphere preventing heat from escaping into space. The Intergovernmental Panel on Climate Change concluded that there is a 95% probability that greenhouse gases from human activities is responsible for most of the observed increase in temperature over the last 50 years.

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2. Evidence includes: • Sea level rise: The global sea level rose around 8 inches in the last century. Recent increases in sea level are nearly double that of those in the past century. • Global temperature rise: Average surface temperature has risen about 1.1 degree Celsius since the late 19th century, with most of the warming occurring over the past 35 years. 16 out of 17 warmest years on record occurred since 2001. • Warming oceans • Shrinking ice sheets: Ice sheets in Greenland and the Antarctic have decreased in mass (at least 36 cubic miles each between 20022005/06) • Declining Arctic sea ice • Glacial retreat: And decreased snow cover in the Northern Hemisphere • Extreme events: Including intense rainfall and record-high temperatures • Ocean acidification 3. Future consequences include: • Longer frost-free and growing seasons: This affects agriculture. • Droughts and heat waves: They will occur more often and become more intense. • Stronger and more intense hurricanes. • Rising sea levels: Combined with storm surges and high tides, rising sea levels will contribute to increased flooding in many regions. • The Arctic Ocean is expected to become ice free in the summer before 2050. 4. While the effects of climate change are detrimental to many, some parties benefit from climate change and would oppose policies aimed at mitigating its effects: • Longer frost-free and growing seasons: Farmers benefit from being able to grow their crops for a longer period of time. • Rising sea levels: Firms with products that mitigate these effects (for example, construction companies that build sea walls) benefit. • Ice-free Arctic Ocean: Shipping companies benefit from being able to travel along the Arctic Circle, which is shorter (and hence cheaper) than travelling across the Indian Ocean.

EXERCISE 20.3 CHOOSING ABATEMENT STRATEGIES Look at the high-cost abatement strategies that we use to illustrate an inefficient abatement policy in Figure 20.12. Can you think of reasons why these policies might be introduced instead of the more costeffective ones?

Answer Less cost-effective policies may be introduced instead of more cost-effective policies because they build on existing infrastructure and are therefore more convenient. For example, coal CCS involves capturing waste carbon dioxide from sources such as fossil fuel power plants, and hence can be added to existing power plants. More cost-effective policies such as geothermal energy require new infrastructure to be built, which make them inconvenient despite their cost effectiveness. These policies may also be less politically popular because there are obvious short-term economic losses from implementing them, and special interest groups may pressure the government to not adopt

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them. For example, reducing pastureland conversion or slash and burn agricultural conversion may be unpopular among farmers.

EXERCISE 20.4 OPTIMISTIC AND PESSIMISTIC POLICIES In Figure 20.14, we described how a policymaker representing a uniform group of identical citizens chooses the optimal amount of abatement. 1. Draw the indifference curves of the policymaker if she were to represent two different groups of citizens (again, we assume that all citizens in each group are identical, and the marginal utility of consumption and environmental quality are both constant). In the first group, citizens care more about environmental quality than consumption, and in the other group, citizens care more about consumption of goods and services. Explain why the optimal level of abatement costs will differ across groups. 2. Now consider the example in the text of the abatement of global greenhouse gases. What are the main simplifications in the model that might lead the policy maker who uses this model to ignore important aspects of the problem of global greenhouse gas abatement? In reality, there is uncertainty about the effectiveness of abatement expenditure and hence how costly abatement of environmental damage will be. 3. On a new diagram, draw the feasible consumption frontier based on an optimistic assessment of the costs of abatement. 4. Now draw the feasible consumption frontier based on a pessimistic assessment of the costs of abatement on the same diagram. 5. By adding the policymaker’s indifference curves to your diagram in each case (assuming all citizens are identical), show how actual environmental quality chosen by the policymaker will differ, even if preferences are the same, depending on whether costs of abatement are assessed optimistically or pessimistically.

Answer 1. If citizens care more about environmental quality than consumption, the slope of their indifference curves will be less than 1 (in absolute value). Conversely, indifference curves of citizens who care more about consumption than environmental quality will have a slope of greater than 1 (in absolute value). The level of abatement is greater when citizens care relatively more about the environment (X compared to B).

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2. Problems with this model include: • The assumption that all citizens have the same preferences: Often, different groups in society place a different value on environmental quality, and some groups are affected more by abatement policies than others, leading to conflicts of interest. Policymakers face the challenge of aggregating these different preferences into a single indifference curve. • Uncertainty over the size of the feasible set and the cost of each abatement method: These estimates affect the size and slope of the feasible set and hence the optimal point. 3., 4., and 5.

Under an optimistic assessment, the feasible set is larger (it is possible to achieve a higher quality of the environment for every given level of consumption). If it is steeper than the “pessimistic feasibility frontier” at any given level of abatement costs, then the optimal level of abatement is higher under an optimistic assessment than under a pessimistic assessment (A compared to B).

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EXERCISE 20.5 ASSESSING CAP AND TRADE POLICIES 1. Explain why the green area in Figure 20.16 represents the total gains from trade. Hint: think about the first permit that Firm B buys from Firm A. How much is the most that Firm B would have been willing to pay? How much was the least that Firm A would have been willing to accept in order to part with the permit? 2. How would you explain the way a cap and trade policy works to someone who has not studied economics? How would you respond to their concerns that the policy is likely to be ineffective or unfair? Many newspapers and blogs publish ‘op-eds’, that is, opinion editorials from the public. A common length limit is 600 words. Find some op-eds on climate policy, and having looked at how they are written, draft your answer to this question in the form of an op-ed.

Answer 1. Firm B pays Firm A an amount of P* per unit for the right to pollute, but in the absence of trade, Firm B would incur the costs of abatement (the ray DX). Firm B’s gain from trade is therefore the green area above the red dashed line at P*. Firm A would be willing to accept a price equal to its MPCA (the ray CX) in order to increase its level of abatement from C to X. Since Firm A instead receives P*, its gain from trade is the green area below the red dashed line at P*. The green area thus represents the total gains from trade (sum of Firm A and Firm B’s gains). 2. A cap and trade policy limits the amount of total emissions, and ensures that firms who undertake abatement are those who find it the most cost-effective to do so. Firms are assigned permits to pollute, and can trade permits amongst themselves until each firm is satisfied with the amount of abatement they should undertake (an efficient outcome). This policy may be ineffective if the government sets the cap too high or makes the permits too cheap, so that polluting now becomes profitable. Setting a limit on how low the price can go (a price floor) can mitigate the pricing issue, to ensure that prices do not send the wrong signals to polluting firms. This policy may be seen as unfair by some people who think that the permit to pollute relieves the firm of any ethical responsibility to protect the environment. The government can use cap and trade alongside subsidies of environmentallyfriendly production technologies, to incentivize bigger polluters to switch to cleaner production methods.

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EXERCISE 20.6 A SUCCESSFUL TRADABLE EMISSIONS PERMIT PROGRAM The cap and trade sulphur dioxide permit program in the US successfully reduced emissions. The program costs were approximately one-fiftieth of the estimated benefits. Read Robert Stavins and colleagues’ views on the US sulphur dioxide cap and trade program at VOXeu.org (http://tinyco.re/7237191). 1. In the view of the authors, why are cap and trade systems such powerful tools to achieve reductions in emissions? Also read ‘The SO2 Allowance Trading System’ (http://tinyco.re/6011888) (by Richard Schmalensee and Robert Stavins of the MIT Center for Energy and Environmental Policy Research. 2. Summarize the evolution of permit prices using Figure 2 in the article. 3. How well can the price movements in permit prices be explained by the analysis in Figure 20.16? Look again at Hayek’s explanation of prices as messages (Unit 11), and the analyses of asset price bubbles (Unit 11) and housing bubbles (Unit 17). 4. Could we use similar reasoning to explain price movements in Figure 2 of the paper by Schmalensee and Stavins?

Answer 1. Cap and trade systems are powerful tools because they are cost effective (minimize the aggregate costs of pollution reduction), and give the private sector the ‘flexibility to pursue a range of abatement options that can simultaneously protect the environment, stimulate innovation and diffusion, and reduce aggregate costs’. 2. According to Figure 2 in the article, permit prices were stable throughout the program’s first decade, spiked sharply, and then fell as quickly as they had risen, below initial levels. 3. The analysis in Figure 20.16 suggests that the permit price depends on the relative marginal private costs of abatement across firms. However, the article mentions that the price changed dramatically due to reductions in the cap (through the introduction of the Clean Air Interstate Rule), and then other regulations that made the cap and trade system nonbinding. The role of regulation was not explicitly discussed in the model underlying Figure 20.16. 4. Some of the reasoning behind Hayek’s explanation and price bubbles applies to the SO2 permit situation. Prices did act as signals of the value of participating in the permit market, with a price increase following a reduction in the supply, and a price decrease following a reduction in demand (after other regulations made permits nonbinding). The price movements look similar to that of asset prices in Figure 11.15 (reproduced below), and may have been partially motivated by self-reinforcing cycles i.e. fears that the cap and trade market

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would be made redundant would cause permit prices to fall, which would spark further falls.

EXERCISE 20.7 WOULD A CARBON TAX REDUCE EMISSIONS MORE THAN REGULATION? In 2017, economists Martin Feldstein and Greg Mankiw (respectively economic advisors to US Presidents Ronald Reagan and George W. Bush), together with Ted Halstead, a climate campaigner, suggested in the op-ed ‘A Conservative Case for Climate Action’ (http://tinyco.re/8116600) that an ideal climate policy in the US should consist of three parts: • • •

A single carbon tax should replace all regulations that are aimed at reducing carbon emissions. Revenues collected from the tax should be refunded to American taxpayers in quarterly paychecks (‘carbon dividend’). American firms that export to countries without carbon taxes should not pay a carbon tax, while importers should face an import tax on the carbon contents of their products (a ‘carbon border adjustment’).

1. Explain the economic reasoning behind each part of the proposal. 2. Why do the economists think replacing regulations with a single carbon tax would be more efficient? 3. Some environmental groups oppose the carbon dividend. They argue that the money could be better spent. Do you agree? What should carbon revenues be spent on? Do you think citizens are more likely to support a carbon tax if there is a carbon dividend? 4. Why do the economists think a border carbon adjustment is necessary? What would be the effect of a domestic carbon tax without a border carbon adjustment? What incentives does it create for American companies and for foreign companies? Is it fair on firms from developing countries (who often generate a lot of electricity from high emissions coal) who export their products to the US? 5. Do you support the proposal by Feldstein, Mankiw, and Halstead. Explain why or why not. What changes would you make?

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Answer 1. Part 1: A carbon tax directly affects the price of polluting, forcing firms to internalize the external costs of their production. Part 2: Outside parties who are affected by pollution are compensated through the ‘carbon dividend’. Part 3: The carbon tax forces importers to internalize the external costs of their products, and protects domestic producers, while the tax exemption on American exporters keeps their exports competitive. 2. Taxation uses price signals to force firms to account for the social costs of pollution, and taxes place a relatively small administrative burden compared to emissions regulation. It can be difficult to detect whether or not a firm is complying with an emissions cap, and it would be costly to monitor every firm. Taxes are therefore more efficient than other methods of pollution regulation. 3. If the aim of the carbon tax is to improve environmental quality, then a lumpsum refund to taxpayers could be better spent on methods that further this aim. For example, tax revenues could fund R&D of cleaner production technology, or on abatement methods (e.g. carbon capture and storage). It is possible that taxpayers would use the refund to consume goods that are harmful to the environment, such as more petrol or non-recyclable goods, which would offset the positive environmental effects of the tax. 4. A border carbon adjustment on imports makes them more expensive, which offsets the effects of the carbon tax on the price of domestic products (domestic producers may try to pass the tax on to consumers via higher prices). Domestic producers can therefore compete with foreign producers even with the carbon tax, which may not be possible if there was a domestic tax without a border carbon adjustment. This adjustment may disadvantage developing countries whose growth is driven by export industries. A considerable proportion of existing greenhouse gases were generated by developed countries (for example, during the Industrial Revolution), so it may be unfair to make developing countries pay. However, the tax may make foreign countries seek cleaner technologies in order to lower import prices, which can benefit the environment. 5. Students will provide their own analysis.

EXERCISE 20.8 WEALTH AND NATURAL CAPITAL Download the World Bank data in ‘The Changing Wealth of Nations’ dataset (http://tinyco.re/8096132). 1. Using the total wealth data, calculate the change in natural capital between 1995 and 2000 and between 2000 and 2005 in absolute terms for three high income, middle income, and low income countries. Summarize and interpret your results. Go to the World Bank’s open data website (http://tinyco.re/8085370). Find and download GDP (in constant prices) for your chosen countries for 1995, 2000, and 2005. 2. Calculate the change in GDP between these periods in absolute terms. Draw a scatter plot with the percentage change in GDP on the vertical axis and the percentage change ...